European Bonds are becoming more at risk than Treasuries


Fund Commentary
17 Feb 2017


In January, US economic indicators were encouraging as consumer confidence and consumption remained strong. Inflation was on the upside and the only dark shadow was disappointing unemployment figures and Q4 growth. Ms Yellen admitted that the US economy was near maximum employment and inflation was moving towards the Fed’s target.

Despite this encouraging news, the Fed still seems reluctant to adopt too hawkish a policy as the dollar remains stronger and uncertainties are growing surrounding Mr. Trump’s policies (fiscal in particular). For the time being, the Fed still forecasts three rate hikes of 25bps this year. In Europe, the economy was still improving as German industrial output and French business confidence dominated a series of economic data, while inflation started to rise in France, Italy and Spain. More importantly, German inflation climbed to 1.7%, close to the 2% ECB target. This data is probably the most important to watch in the coming months as the Germans (including the Bundesbank’s chairman Mr. Weidmann in particular) are increasing the pressure on the ECB to stop its ultra-accommodative monetary policy. Within the ECB itself, there is no unanimous consensus regarding the future of quantitative easing after December 2017, i.e. whether to extend or taper. The behaviour of the ECB will also depend on the outcome of crucial elections in the coming weeks; on 15th March in the Netherlands and in April-May in France. Last but not least, Greece has EUR 13 billion of debt payments due in July…

In this context, the US Treasury yield curve barely moved, the 2y US Treasury went from 1.19% to 1.20% (+1bp), the 5y from 1.93% to 1.91% (-2bps), the 10y from 2.44% to 2.45% (+1bp) and the 30y long bond from 3.07% to 3.06% (-1bp). At the same time, the 30y inflation-linked Treasury yield decreased from 0.99% to 0.93%, leading to a small increase of the inflation breakeven from 2.08% to 2.13%. In Europe, the German curve started the new year with a bearish steepening move, the 2y yield increasing from -0.77% to -0.70% (+7bps), the 5y yield from -0.53% to -0.40% (+13bps) and the 10y Bund from 0.21% to 0.44% (+23bps). At the same time, the Italian 10y yield increased from 1.81% to 2.25% (+44bps) while the Spanish 10y bond yield “only” climbed from 1.38% to 1.59% (+21bps, i.e. in line with the correction of the Bund yield). On the credit side, the European iTraxx Main hardly moved, increasing from 72 to 74bps while the US corporate CDX index decreased from 68 to 67bps. In Emerging Markets, the CDX 10y EM index widened slightly from 286 to 291bps (+5bps).


During the month, the Investment Adviser continued to favour investments in Floating Rate corporates (non-Financials), i.e. bonds with low duration (between 0 and 0.3) and coupons indexed on the 3 month Euribor. The weights of General Electric, 3M and Honda were increased. The Fund has been active in the primary market, investing in the new 4y issue from Deutsche Telekom and in the new 5y Auchan. These two new bond purchases have been financed by decreasing the weight of ICO 2021 (PSPP, Spanish government guaranteed) and OEBB Infrastruktur 2020 (PSPP, Austrian government guaranteed). The duration has been slightly decreased from 2.5 to around 2.4. In terms of portfolio diversification, the Fund held 36 issues from 35 different issuers.


During the month, the Investment Adviser continued to favour investments in Floating Rate Notes, i.e. bonds with low duration (between 0 and 0.3) and coupons indexed on the 3 month USD Libor (which reached 1.03% at month end). The weights of Ford Motor Credit FRN 2019 and Siemens FRN 2018 (against the sale of Siemens 2018 fixed) have been increased. He also increased the position in Tesco 2017 and bought Iberdrola 2019 against a decrease of the weight of TIPS 2043. Finally, the weights of the following bonds have been decreased as they reached almost 5% of the portfolio: OKB 2017, EDF 2019, EDC 2018, Enel 2019, KfW 2021 and Roche 2024. As a result, the modified duration decreased from 3.8 to 3.6. In terms of portfolio diversification, the Fund held 42 issues from 37 different issuers.


In January, no trades were executed in the portfolio as emerging bonds continued to rally and assets under management were stable. In terms of geographical breakdown, the top 3 countries were Russia (19.1%), Brazil (10.8%) and India (8.1%). The rating allocation was 49.8% Investment Grade and 47.1% Crossover (BB+ and BB). The breakdown of the portfolio in terms of market allocation was 96.9% Emerging Markets and 3.1% cash. In terms of sector allocation, the Investment Advisor favoured Governments (32.4%) followed by Materials (18.2%) and Energy (17.7%). The modified duration decreased slightly from 5.9 to 5.8 during the month. In terms of portfolio diversification, the Fund held 35 issues from 35 different issuers.


The The Investment Adviser’s global outlook has become more cautious. The sell-off in the Treasury market could continue in Q1 2017 and the spread between the 10y US Treasury and the German Bund could narrow from almost 200bps today (which is a record high) to its long term average around 160bps. It means that US bonds could suffer substantially in the coming months but European bonds could be even more at risk. Should 10y Treasuries increase to 3% and the spread Treasury-Bund tighten at the same time, the 10y German yield could potentially rise from 0.4% to 1.4%. This worst case scenario could be possible under three conditions: the improving economic situation in Europe, the uncertain (and potentially dangerous) outcome of elections in Netherlands and France and finally a possible key change in the behaviour of Mr. Draghi, preparing markets for a tapering in January 2018. It means that February will be a crucial month for the three bond funds as the Investment Adviser will take any opportunity in the markets to substantially decrease the duration risk of the portfolios. In addition, the huge rally in Emerging Markets could lead the Investment Adviser to take profits on some high-beta countries and reinvest in more “low risk-low volatility” regions.


The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 15/02/17 and are based on internal research and modelling.